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Do a Few Good Weeks Portend a Good Year Ahead?

CRE Firms Herald Flurry of Late Year Deals Even as Some Worry Investment Activity Driven More by Policy Than Property Economics
January 23, 2013
Clarion Partners, a leading New York-based global investment manager, epitomizes what has been occurring in the U.S. commercial real estate investment sales market over the past few weeks. Clarion has been on a tear, as has the investment market.

· In a joint venture with MetLife Real Estate Investors, Clarion purchased the 1.4 million-square-foot Constitution Center, the largest, privately-owned, trophy office building in Washington, DC, for $734 million.
· Acting on behalf of a separate account client of the firm, Clarion paid $129.3 million for a six-property, 407,458-square-foot office portfolio in the Four Point section of Boston’s Seaport District.
· In New Jersey, Clarion paid $76 million for the 353-room Hanover Marriott on behalf of an institutional investor.

Three huge deals that closed in a span of few short weeks, which has been the story for much of the CRE market as we’ve rolled into 2013. Cassidy Turley estimates the uptick in deal volume at the end of 2012 was close to 20% above historical norms.

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But the big question on nearly everyone’s mind is: Can it continue?

Tim Wang, a director, head of investment research and a member of Clarion’s investment committee, thinks so, and says compared to other options available to investors, CRE is very attractive right now.

"The European sovereign debt crisis seems to be stabilizing. China’s economy has rebounded. The U.S. is finally ready to confront our budget deficits and long-term structural issues," Wang said. "So, on balance, the economic outlook is relatively positive. On the other hand, investors are facing a volatile stock market and ultra-low bond yields. High quality commercial real estate is a logical choice for investment today."

That sentiment is shared by research analysts at most commercial real estate firms across the country, although some are concerned the deal flow seems to have more to do with policy matters and tax avoidance rather than underlying economic and property fundamentals.

"Though investor demand for multifamily, CBD office, trophy shopping centers and net leased investment remains extremely high, the late year flurry of deals that we saw in December had more to do with fear of 'taxmageddon' than anything else," said Garrick Brown, director of research at Cassidy Turley in San Francisco. "If anything, I think this trend does not speak to underlying economic fundamentals but ongoing policy concerns."

And that, Brown said, is very good news.

"Policy concerns are now the greatest threat to the economy-not weak underlying economic fundamentals," Brown said. "And though the fiscal cliff deal was wanting and certainly set the stage for more discord with debt ceiling II, I also think that the worst short-term damage was averted with that deal. Business confidence is up.

"Though it didn’t have a huge impact on pricing and cap rate trends, we did see some sellers whose pricing had previously been set in stone suddenly accept offers they had previously rejected to close deals," Brown continued. “But we also saw a lot of activity from people who contacted us late in the year simply looking to sell a property quickly.”

Jacques Edelin, director of research at Newmark Grubb Knight Frank in New York, said underlying business conditions could put a damper on the investor enthusiasm of the last few weeks.

"Corporate earnings growth for the big S&P 500 companies turned negative in the third quarter of 2012 for the first time in 11 quarters (nearly three years), which means the economy is not improving despite what the media and politicians are telling us. That doesn’t bode well for 2013," Edelin said.

So what’s an investor to do?

"The key challenge for core investors in 2013 will be availability of properties for sale," said Lee Menifee, managing director, research and strategy at American Realty Advisors in Glendale, CA. "With foreign investors, REITs, pension funds and retail investors all poised to increase their exposure to U.S. real estate, there may not be many sellers, and the high quality properties that come onto the market will spark intense bidding wars. But investors who choose to sit on the sidelines in the coming year are likely to find the 2014 environment similarly competitive, and will miss out on a year of attractive income returns and potential appreciation."

Menifee expects value-added and opportunity investors will find competition even more fierce this year than last.

"Many troubled assets are 'self-curing' due to rising property values, reducing the number of distressed sales," he said. "Instead of distressed owners, value added and opportunity investors increasingly will have to buy distressed assets, which are always more challenging and expensive to reposition."

As always in commercial real estate, a key to sustained growth will be financing.

Menifee said he beelieves the net deleveraging of commercial real estate will constrain value growth, particularly in tertiary markets. "Despite the growing availability of debt for core properties, banks and most other lenders are decreasing their exposure to U.S. real estate," he said. "CMBS markets could play a bigger role in 2013, but investor demand is as likely to ebb as it is to flow, depending on the regulatory environment and perceptions of the quality of the underlying properties."

CoStar asked other CRE professionals for their take on how they expect 2013 will progress based on their experience over the past few weeks. Here are some of the additional responses:

A Better Year Than 2012

One or two good months does not a “trend” make! That said… I do believe that 2013 will be a better year than 2012. We are certainly experiencing an uptick in activity in our Tucson office market, in both sales and leases. Even the general “chatter” in the street is a bit more intense. Some of it is due to pent-up demand in requirements to purchase or lease. Some of it is due to a feeling of more confidence in what the future will bring.

But I expect this increase in the level of activity will be fragile and the day-to-day news coming out of Washington, as well as state and local governments, will have great effect on the direction of this “trend.”

I do believe we are recovering. But the pace will be slow enough that it won’t really feel like things are getting much better until the day sneaks up on us and we realize that it’s happened!
Thomas J. Nieman, principal, commercial properties at Cushman & Wakefield | Picor Commercial Real Estate Services in Tucson

More Deals Because There Are More Options

As cap rates compress too low for many investors for core assets in the most sought-after gateway markets, more investors are open to secondary markets and lesser-quality assets to achieve reasonable returns. There are more acquisition options as investor criteria expands.

Most investors feel this is a great time in the cycle to acquire real estate. Now that values are clearly on the rebound and most markets are seeing improvements in occupancy and rates, investors are less apprehensive about the market. Sellers feel pricing has improved enough to sell. Sellers feel better about selling assets now than they have in four years, so there are more willing sellers.

In some property sectors and market areas, values are still less than replacement costs. Plus new development is still more difficult to finance. This further drives the acquisition vs. new development decision toward acquisition.
Michael Bull, president at Bull Realty Inc. in Atlanta

Unless Washington Mucks It Up

We expect the recovery to show some acceleration in 2013. It has been a long, slow road to get to this point, but we believe that the business community’s confidence levels are finally returning to a level of equilibrium. Provided Washington does not dislodge that confidence, the fundamentals also appear to point to higher levels of real estate activity across most sectors.

I would describe the ingredients as a combination of improving confidence, positive growth from the housing sector (which has been a major detraction for several years), a healthier financing environment and an employment market that is not strong, but is trending positively. These economic fundamentals are set against a backdrop of limited new supply in the real estate market, so any pickup in demand is having a meaningful impact on the markets.
James R. Wrigley, executive vice president of Trefoil Properties LP in Lansdale, PA

Absorption Will Be Key

Class A office in Dallas seems to be selling well. Class B office fundamentals seem to be improving finally, but most B and C buildings are not primed for sale due to low occupancies and low rental rates. Some Class A owners may feel that their in-place rental rates are still too low to sell despite higher occupancies. It seems unlikely that cap rates will decline further and likely will remain flat for next few years.

Owners of Class B office should be hoping that Class A office rates and occupancies are becoming high enough to be restrictive to tenants and that Class B buildings will therefore benefit. I think that this may begin in 2013. There are statistics and anecdotal evidence to indicate that concessions are diminishing and that tenant’s leverage has already peaked and is on the decline.
Ryan Phillips, president of Signature Asset Management Inc. in Dallas

I track absorption closely and it has been increasing steadily each quarter. Vacant spaces need to be absorbed before landlords can get any real pricing power. We are probably 12 months away from any price increases.
Todd Hamilton, associate broker at Cutler Commercial in Phoenix

Employment Primary Driver of Recovery

We believe activity will be firing on all cylinders and continuing the momentum over the past two months. This includes sales velocity, better occupancy, less concessions, more development, continued cap rate compression for core product in core markets and more investment capital in secondary and tertiary markets.

Employment tends to be the primary driver of this CRE recovery. You are seeing stronger employment numbers in the core markets which is increasing occupancy for office product, more discretionary dollars for retail spending and increased confidence by both companies and investors to put their money back to work. In addition, the low interest rate environment is allowing for continued momentum for both buyers and sellers.
Joel Dumes, vice president of investments from The Dumes Falk Group of Marcus & Millichap in Cincinnati

Still Too Early To Tell

The market continues to be a story of haves and have-nots. Some real estate firms have embraced the new economy, and are doing business in a new way. Much of that requires learning and letting go. Some firms have, and some have not.

The market is different than it was in 2006 and even 2010 for that matter. We’ve reached a peak and a bottom both over the last five years. Values have been rising. There is job growth, it is modest, but it exists. Most importantly, there is money. Debt and equity capital is readily available for trophy deals, value add deals so long as they are priced correctly.

Bottom line, 2013 will likely be ok or good. I don't expect it will be great.
Aasif M. Bade, president of Ambrose Property Group in Indianapolis

The New Normal

I think it only signals that the market has adapted to a new normalcy, which should continue in 2013. Retail sales have been near or above pre-recession highs for two years. Unemployment is the only thing holding the recovery back farther. The divergence of the two (retail sales and employment) suggests two things. Firstly it signals a structural retrenching where the outcome of the retooling of corporate America in response to the recession - i.e. more efficient operations doing more with fewer employees.

Secondly, the lag in construction-related activity (which we know to be true) vs. retail sales has been somewhat surprising to some, but requires the full repricing effect on home ownership to finally work most of the way through the system.
Gabriel Silverstein, president of Angelic Real Estate LLC in New York

Bearish Sentiment Should Subside

We glided off the cliff mostly unscathed, Europe seems to be relatively stable, and housing inventory seems to have dwindled (even the shadow kind) due to a rush of enthusiasm for discounted/distressed housing in 2012. Overall, very few clouds ahead - corporations should begin spending and expanding, which should propel job growth, and investment activity should continue with less uncertainty in the air. Provided that we don’t have any surprises, bearish sentiment across the country should begin to substantially recede in 2013.
Nelson B. Garcia, managing associate at CGI Merchant Group in Miami

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